CALIFORNIA REAL ESTATE JOURNAL January 3, 2006 Lenders Cashing In on Construction -- Investors more focused on nonresidential development as acquisition returns stay low BY MANDY JACKSON CREJ Staff Writer Lenders are placing big bets on development, expecting risk to be trumped by reward. Although construction financing may be a bigger gamble than funding acquisitions, banks, mezzanine investors, equity providers and other capital sources are willing to take the chance as commercial real estate markets improve around the state. "There are different stories in different markets. Some markets are going gangbusters vacancies are low and they're seeing upticks in construction," said Jamie Woodwell, senior director of commercial and multifamily-housing research for the Mortgage Bankers Association in Washington, D.C. "There are other markets where vacancies are sort of remaining stubborn and there's not much construction," Woodwell said. Clearly very focused on the markets that are doing well, commercial and multifamily-housing mortgage lenders set new records during the third quarter, according to MBA. They originated $58.4 billion in loans, which represented a 64 percent increase from third quarter 2004 and a 31.2 percent rise from second quarter 2005. MBA reported that third-quarter lending increased from the same period last year by 55 percent for office properties, 45 percent for multifamily housing, 33 percent for retail, 80 percent for industrial and 531.6 percent for hotels. Hotel lending increased five-fold because of a dramatic rise in development, according to MBA. "I would say about 60 percent of our financing in Southern California is construction financing," said Greg Rickard, senior vice president and district manager of KeyBank in Los Angeles. Most of the Cleveland-based bank's recent Southern California activity involved apartment and retail loans in the $30 million to $40 million range. "It takes borrowers two to three years to get their entitlements. People have reloaded their development pipelines," Rickard said. With the run-up in real estate values and rents, an increase in development seems to be justified. However, Rickard said that construction and development funds are not necessarily coming from new lenders. The same lenders who always have specialized in that type of financing are just doing more of that business. The 30- to 90-day delinquency rate for commercial real estate loans at commercial banks, excluding construction lending, was only 0.15 percent at the end of September and 0.27 percent for multifamily-housing transactions, Woodwell said. Noting the slightly higher risk in funding development, he said the delinquency rate of 0.58 percent for both residential and commercial construction was higher than delinquency for acquisition financing, but the number is still very low. Although traditional banks remain somewhat leery of construction lending, often requiring significant preleasing and funding only two-thirds of building costs, mezzanine lenders, equity providers and nontraditional financial-service companies are happily picking up the slack. Tim Wright, senior managing director in the San Diego office of Holliday Fenoglio Fowler LP, said traditional banks, such as Wells Fargo, Bank of America and Chase, have been disciplined investors, for the most part. However, those lenders have been usurped by nontraditional sources, such as Fremont Investment & Loan. Fremont is a portfolio lender whose commercial-property division, based in Brea, is staffed by employees with real estate expertise. Although its interest rates are higher, Wright said the financial-services company will fund a larger percentage of construction, because Fremont's staff understands the risk involved in development. Lenders Not Looking at Leasing Mezzanine lenders remain active, as well, hoping their gap financing might be an entree into owning real estate when construction is complete and loans go unpaid. "For some mezzanine lenders, it's the only way they can acquire property," Wright said. Mezzanine lenders understand the risk involved in development, so they are prepared to deal with a project owner who defaults on a construction loan because they have the fina ncial capability to wait and sell a property for the highest-possible price. In the competitive commercial real estate market with billions of dollars vying for a limited amount of new construction, some lenders have lowered their preleasing requirements to fund projects, Rickard said. Retail in mixed-use development is often funded with little preleasing. And because a lot of industrial development is done in markets with only 2 percent to 3 percent vacancy, those projects are often financed with no preleasing, Rickard said. "It seems to me that the construction-lending community is still pretty disciplined in terms of preleasing requirements. But there are a lot of lenders out there, so it's competitive," Wright said. He represented San Diego-based Cisterra Partners LLC and Prudential Real Estate Investors this fall in arranging $100 million worth of two-year, fixed-rate construction financing through Pacific Life Insurance Co. for the 14-story, 308,000-square-foot DiamondView Tower office building under construction in downtown San Diego. Holliday Fenoglio also arranged a $22 million bridge loan through Pacific Life to finance land acquisition and predevelopment work for the project. "Leasing wasn't the hurdle we needed to reach," said Jason Wood, director of development for Cisterra Partners. DiamondView Tower, which is due for completion in first quarter 2007, is under way at 10th Avenue and J Street behind right field of 42,000-seat Petco Park baseball stadium. The first two floors will be leased to retailers and restaurants. The building is 33 percent preleased to Cox Communications, Comerica Bank and CB Richard Ellis. "For us, [the financing] was based on having everything finalized with the Redevelopment Agency to close on the land on Oct. 19," Wood said. The building didn't have to be significantly preleased to obtain financing because of the unique backing Cisterra has from Prudential. "That partnership opened up a lot of doors to the construction-lending community," Wood said. Cisterra was able to arrange financing for 100 percent of the construction cost because Prudential put up a guaranty that it will pay off the loan when the building is completed, regardless of leasing. "Typically, a developer will get a construction loan and then get a permanent loan that will pay off the construction loan. That's why lenders want to see preleasing, so they know the developer will be able to get a permanent loan," Wood said. "In reality, when the project's complete, we and Prudential hope we have enough preleasing to get a permanent loan. If we don't, Prudential is there to assure the construction lender." Lenders' appetites for most property types - industrial, office, retail and apartments - are growing, but interest in condominium development and condominium conversions is waning. "For Southern California, there's been no slowdown in development. We're seeing that mixeduse and transit-oriented projects are going full speed ahead," said Steven Bram, president of Los Angeles-based George Smith Partners. "We're seeing that lenders are being a little bit conservative on for-sale condominiums, while they're waiting to see how what's out there is absorbed." With a big supply of new condominiums and conversions and evidence that housing price appreciation is slowing, financing has become more selective. "Lenders are taking a good hard look at condominium deals. If they do them, they're looking at if it's an experienced developer with room to sell the units at lower prices," Rickard said. "It's not a good time to develop a highly leveraged project." Lenders aren't afraid of a major market downturn in condominiums or any other real estate segment, Bram said, but they don't want to have too much invested in one property type at any given time. "This has been a good time for industrial and commercial developers because demand is stable," Bram said. "I think that equity will remain available for the good deals." What lenders are afraid of is rising construction costs. "Construction costs have increased maybe 20 percent over the last 18 months, whereas rents haven't increased that amount, so projects must be economically sound and construction costs must be completely checked out prior to determining the economic viability of the deal," Bram said. "Lenders are fearful of additional cost increases and are looking carefully at the strength of the completion guarantees." Still, development financing may look more promising to some lenders as capitalization rates continue reaching all-time lows for commercial real estate acquisitions. "A lot of that investment capital is very frustrated that it is seeing less returns than historically expected. So they're going into construction, and they have to wait three or four years for returns," Rickard said. "It does make it a good time if you're a developer to go out and attract capital."